The Fed is Making us all into Stepford Wives
We had a few brief moments of excitement this week. The S&P 500 actually managed to go lower for two days in a row. Below the surface, credit felt on the cusp of a larger move. Looking at high yield ETF’s, HYG hit a high of almost 95 last week, and got to a low of 93.60 on Thursday (it closed lower Friday, but that was ex dividend). That is a significant move. JNK had a similar week and remains at a discount to fair value. Both of those funds had net redemptions on the week as did the investment grade version.
IG19 closed last week at 85 and traded as high as 91.5 on Thursday morning when there was some real fear.
But the morphine of the Fed induced liquidity kicked in by Friday and everything was good again.
Or was it good again?
Before seeing what if anything was wrong, let’s go through the bull case quickly:
- QE is helping housing
- QE is providing money that is getting pushed into stocks
- QE is happening on a global basis so it isn’t just here that we are getting QE inspired growth
- All good data is a sign that QE is working
- All bad data just means QE hasn’t had enough time to work and is actually good for the markets because it ensures that QE will be around for longer
- The rotation out of treasuries is a sign that QE is working and investors are rotating into stocks, and is not a danger because the economy isn’t relying on low rates, except that low rates helping housing was one of the first starting points of the bull case
I can see a lot of the arguments used by the bulls, and don’t think we are horribly overvalued, but the almost comatose way the market is behaving is starting to scare me.
Let’s take a quick look at things that the market seems to believe in, that might not be true, and some things that we seem to be ignoring.
Corporate Bonds had a Wile E Coyote Moment
There was a brief moment on Thursday when virtually every corporate bond investor was waiting for someone else to buy the dip. We had that moment where the coyote had run over the cliff and was suspended in air. There were no dip buyers:
- Retail is pulling out of corporate bonds, not in a massive way, but certainly not providing the non-stop bid that was there for much of last year
- Pension funds and insurance companies seem to be on hold. They own a lot of bonds, and with yields moving their direction seem patient
- Hedge funds seemed to be caught a little long. No panic, but were really looking for someone else to step in and buy bonds
In the end, stocks came to the rescue, CDS tightened, and bonds finished “okay”. High yield at least had a good day on Friday, but investment grade bonds had a “good” day for spread buyers, but not so much for yield buyers. The typical retail investor owns bonds on a yield basis and saw Friday as yet another down day. LQD is down almost 2% in a little over a week, which given the sub 4% yield, means it has given up almost 6 months of carry. Watch this.
Spain and Italy are Fixed, at least according to the politicians
While politicians continue to talk about how great Europe is looking, and we here in the U.S. ignore it, the Spanish and Italian markets had some trouble.
Spain was hit the worst with IBEX dropping from 8,724 to 8,229 in one week. The Italian MIB index also dropped from a high of 17,900 on Monday to 17,318.
Stocks are one thing, but we even saw weakness in bonds. Spanish 5 year bonds leaked out 10 bps to finish the week yielding 3.88% while Italian 5 year bonds got whacked by 22 bps to finish the week at 3.13%. This was all spread widening as the 5 year German bund was unchanged.
The 5 year is critical because it is outside the range of ECB lead OMT (open market transactions). It is owned by yield chasers. The countries have been able to issue debt, so for the first time in awhile we actually have some non domestic, speculative investors. They may not be patient with their holdings, especially since very little has changed.
That brings us back to OMT, the plan which was announced back in September, but hasn’t actually been implemented. For all the comfort the market has taken with OMT, neither Spain nor Italy have agreed to a program.
Since it is corruption allegations against Rajoy that sparked this weakness, it might not be easy to hammer out an agreement if necessary. Even the IMF would probably not want to be responsible for setting up a program risking everyone’s money with a politician in the middle of a corruption scandal. Even if the IMF and ECB were willing to, someone in Germany is likely to make a stink about giving money to that sort of a person?
So OMT is not yet agreed to, and Spain is mired in accusations of corruption, and Italy is preparing for elections.
Last year in mid March, Spanish bond yields were creeping up, in spite of LTRO. No one noticed, and two weeks later they were front page news and dragging the market down. History may not repeat, but this is worth watching.
Fund Flows Show Retail Returning to Equities
While fund flows are higher than in long time, I am not sure this truly reflects a return of the retail investor. Somehow most pundits continue to believe retail only buys high and sells low and that 14,000 on the Dow is going to encourage yet more buyers.
I see the fund flow data decreasing. It was higher at the start of the year, and has since decreased. Could there be any other explanation? Part of the explanation may be that we don’t seem to track as regularly how much is invested in single stocks. So is it possible that retail sold stocks last year and bought mutual funds?
- With all the uncertainty surrounding the fiscal cliff, many people were being advised to sell stocks to lock in capital gains. That would have left them underexposed to the market. Post fiscal cliff resolution, that money would be re-invested, but possibly many long term individual stock holders re-invested in mutual funds or ETF’s because they didn’t want to invest in single stocks, or they were concerned about getting caught up in wash sale rules. This seems somewhat plausible.
- Special dividends were the rule of the day. Costco paid one out on December 5th. It is conceivable that money was held until post fiscal cliff, but rather than being used to purchase more Costco was put into a mutual fund? That would make fund flows positive, but be far from an indication that retail is participating on a new and grand scale.
- Fund flows seem to be slowing, so that might be better explained by my theory that we are seeing a transfer from single stocks and special dividends into mutual funds than a big new round of investments
The other side is that the flows must be out of bonds and into stocks. Yet bond funds haven’t done that poorly, and the flows are small, at least compared to the flows provided by the Fed which are going into bonds, not stocks.
To me, we are seeing some amount of risk transfer where people are moving from bonds into stocks, but that is at the institutional and hedge fund level, not the retail level.
For funds, the only catalyst necessary to go down is for it to go down. Stocks never felt as bad as credit last week, but that feeling the credit markets had could just as easily hit the stock market.
A GREAT Jobs Report
Not so fast. What we chose to look at and what we chose to ignore is pretty telling:
NFP now averaging about 200,000 per month for past 3 months
Household survey averaging -2,000 for the same 3 months
With Revisions, lots of new jobs added
With revisions, the number of jobs being created is declining rapidly, from 247k to 196k to 157k
The U.S. is experiencing a Manufacturing “revolution”
25,000 manufacturing jobs created for past 4 months combined, over past 6 months manufacturing has shed 7,000 jobs. The manufacturing revolution is an appealing meme but is it real?
With so many jobs in November and December How Was Q4 GDP so bad?
Housing is Leading the Recovery
We all seem to believe this, yet the evidence is sparse.
First, the Fannie Mae 30 year mortgage rate hit a low of 2.6% on September 26th, right after the Fed announced plans to buy $40 billion a month of mortgages. It is currently 3.1% so any bounce that was sparked by ultra low rates has to be downplayed at least a little as rates have gone right back up. This is still lower than where it was this time last year 3.3% or so, but headed in the wrong direction.
The housing data has seemed mixed, with NAHB weak, existing home sales down and new home sales down even more. The ever “conservative” builders did do a lot of starts and got a lot of permits, but they have been over enthusiastic before.
You Have to Respect the Resilience, But you Can’t Take it for Granted
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